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Bailouts with TODD KEISTER’S MODEL

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Bailouts with TODD KEISTER’S MODEL Bailouts WITH TODD KEISTER’S MODEL 11/8/2017 XINYI WAN 1 What does it mean A broad definition: “A bailout is a colloquial term for giving financial support to a company or country which faces bankruptcy. “ We’ll be using a (very) narrow definition: “The government bailout a bank in order to prevent greater, socioeconomic failures.” 11/8/2017 XINYI WAN 2 An excerpt from FDIC’s 1984 report… “There were no mobs of frenzied customers outside Continental’s doors. There were just numbers flashing on computer screens, heralding disaster.” – Sebastian Mallaby 11/8/2017 XINYI WAN 3 Moral Hazard – Incentive Problem –the investors –the bank Dynamic Inconsistency – the government’s dilemma Swagal (2010): “[a] resolution regime that provides certainty against bailouts will reduce the riskiness of markets and thus help avoid a future crisis.” Dijsselbloem (2013): “[b]y ensuring that the private sector bears the primary responsibility for bank resolution, market discipline will be increased and a sustainable, healthy financial sector can be achieved.” 11/8/2017 XINYI WAN 4 Bank Depo The Model sitors Governm Basic structure and assumptions ent 11/8/2017 XINYI WAN 5 The Model The depositors • Utility function: • Strategy profile: 11/8/2017 XINYI WAN 6 The Model The bank • (d) Once the bailout is received and any uncertainty is resolved, how should the bank allocate its remaining resources? The bank’s goal: Maximize welfare for the remaining investors 11/8/2017 XINYI WAN 7 The Model The bank • (d) Once the bailout is received and any uncertainty is resolved, how should the bank allocate its remaining resources? The bank’s goal: Maximize welfare for the remaining depositors The fraction of remaining depositors that are impatient 11/8/2017 XINYI WAN 8 The Model The bank • (d) Once the bailout is received and any uncertainty is resolved, how should the bank allocate its remaining resources? The bank’s goal: Maximize welfare for the remaining depositors Subject to: “the bank’s resource constraint” 11/8/2017 XINYI WAN 9 The Model The government • (c) Implement an optimal bailout policy step1: Is there a run? step2: If so, how much bailout payment to give to each bank? 11/8/2017 XINYI WAN 10 The Model The government • (c) Implement an optimal bailout policy step1: Is there a run? If > … “the bank’s resource constraint” 11/8/2017 XINYI WAN 11 The Model The government • (c) Implement an optimal bailout policy step2: how much bailout payment to give to each bank? ( ) The optimal bailout policy equates the marginal value of public consumption with marginal value of private consumption for the remaining investors for each bank 11/8/2017 XINYI WAN 12 The Incentive Distortion • The optimal bailout policy equates the marginal value of public consumption with marginal value of private consumption for the remaining investors for each bank. • Each bank chooses the same values for . • must be chosen such that each bank faces the same resource constraint, in other words, is a constant. • A bank with fewer remaining resources gets larger bailout. 11/8/2017 XINYI WAN 13 Reasons against Bailouts "In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me…” –Ron Paul 11/8/2017 XINYI WAN 14 Future discussion 1. (b): How will the anticipation of a bailout affect the bank’s choice of the amount to give out to each withdrawing investor before the bailout? 2. Possible solution to the incentive problem through (a): How can the government mitigate incentive distortion through tax rates? 11/8/2017 XINYI WAN 15 3. A broader definition of bailout 1970 ‐ Penn Central Railroad 2008 ‐ The Bear Stearns Companies, Inc. 2008 ‐ Fannie Mae and Freddie Mac 1971 ‐ Lockheed Corporation 2008 ‐ The Goldman Sachs Group, Inc. 1984 ‐ Continental Illinois[5] 2008 ‐ Morgan Stanley bailed out by The Bank of Tokyo‐Mitsubishi UFJ 2008‐2009 ‐ American International Group, Inc. multiple times 1995 ‐ Mexico Bailout 2008 ‐ Citigroup Inc. 1997 ‐ South Korea Bailout 2008 ‐ General Motors Corporation 2009 ‐ Bank of America 1997 ‐ Indonesia Bailout 2009 ‐ CIT Group 2009 ‐ Dubai and Dubai World bailed out by Abu Dhabi 1998 ‐ Brazil Bailout[44] 2000 ‐ Argentina Bailout 11/8/2017 XINYI WAN 16 Cited works 1. fdic document on Continental Illinois: https://www.fdic.gov/bank/historical/managing/history2‐04.pdf 2. Ron Paul. 11‐24‐2008, the Bailout Surge 3. wiki‐page cases timeline, https://en.wikipedia.org/wiki/Bailout 4. Todd Keister. Bailouts and Financial Fragility, Review of Economic Studies (2016) 83, 704–736 5. Sebastian Mallaby. “The Man Who Knew: The Life and Times of Alan Greenspan.” 11/8/2017 XINYI WAN 17.
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